Wednesday, March 26, 2008

Due to the size of a potential housing bailout of $1 trillion or more, Reuters UK columnist James Saft argues that it will be very tough for the U.S. economy to avoid inflation:

If the United States bails out the financial system by buying mortgage debt directly, the price just might be surging inflation and a dollar crisis.

Calls are increasing for the government, either directly or via the Federal Reserve, to cut the knot of the credit crisis at a stroke by buying up mortgages that banks and investment banks are finding difficult to finance...

Such a bailout would either have to be paid for by taxes, which seems unlikely, or would involve issuing more government debt or effectively expanding the money supply.

"There would be an inflationary impact because of the huge introduction of credit," said Philip Gisdakis, strategist at Unicredit in Munich.

"It's not $50 billion; we are talking about more like $1 trillion. This injection of capital you need will have consequences for the U.S. economy."

A bailout of that size is very likely to stoke inflation, which is already uncomfortably high, by effectively creating more dollars and putting them into circulation...

To be sure, there is no political consensus for a major bailout, which is openly opposed by the Bush administration and would face serious difficulties gaining agreement in an election year. The U.S. Treasury said on Wednesday that proposals it had seen would do more harm then good.

That is partly why there has been such a startling turn around on allowing Fannie Mae (FNM.N: Quote, Profile, Research) and Freddie Mac (FRE.N: Quote, Profile, Research) to take on more risk and buy more mortgages. While their debt has an implicit government guarantee, they are shareholder owned.

But the $200 billion in new lending allowed to Fannie and Freddie by their regulator, The Office of Federal Housing Enterprise Oversight, might not prove enough...

The question of how deep a dollar fall that implies is really in the hands of the United States' foreign creditors, like China and the Gulf states. Because they peg their own currencies to the dollar, exporting more to the United States than they import, they are regular dollar buyers.

A falling dollar causes inflation for them, a price thus far they have been willing to bear as a cost of a profitable trading relationship.

But eventually, if inflation and a dollar fall interact toxically, support from abroad might just dry up.

"If (foreign creditors) decide that they are not going to accept the inflationary policies of the Fed, you could see a pretty disorderly collapse," said Drayson.

"If we are talking a trillion dollars plus (bailout), it will be quite hard to avoid inflation as a consequence of that."

There are, of course, also consequences to the alternative course, which may lead to a round of failures by financial institutions.